Considerations in Frequent Flyer Program Monetization
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EXECUTIVE INSIGHTS VOLUME XVII, ISSUE 23 Separation Anxiety: Considerations in Frequent Flyer Program Monetization At the time, the pioneering spin-off (and subsequent IPO) of Affinity Equity Partners in 2014 – have prompted airlines to Air Canada’s frequent flyer program (FFP) appeared to usher in revisit the merits of FFP monetization, so long as valued a new era of loyalty program monetization. In many ways, the customer relationships aren’t jeopardized in the process. creative but radical divestiture of Aeroplan in 2005 provided an While it may not be the best choice for all carrier models, alternative pathway in an industry that was grappling with the strategy deserves careful consideration. escalating factor costs, persistent over-capacity and over-leveraged balance sheets. Despite the initial buzz, however, In this Executive Insights, we examine the strategic rationale, managerial apprehension in the years that followed prevented value maximization strategy and separation dynamics associated widespread adoption of the strategy. with carving out all or part of an airline loyalty program across a continuum of strategic alternatives (see Figure 1). More recent successes – including Virgin Australia’s $293 million, 35% divestiture of its Velocity FFP to Hong Kong-based Figure 1 Loyalty Program Development 1 2 3 4 Internal Separated Partial spin-off Spin-off program program program program Fully integrated with Operating as a separate Operating as an Fully divested with only the parent airline for wholly owned independent entity with arms-length linkages to financial and subsidiary of the limited direct airline the parent airline operational purposes parent airline control Separation Anxiety: Considerations in Frequent Flyer Program Monetization was written by John Thomas and Dan McKone, managing directors, and Brett Catlin, an engagement manager, in L.E.K. Consulting’s Aviation and Travel practice. John, Dan and Brett are based in Boston. For more information, contact [email protected]. L.E.K. Consulting / Executive Insights INSIGHTS@WORK® LEK.COM EXECUTIVE INSIGHTS FFP Separation: A Strategic Rationale serve the core airline first instead of migrating to the opportunity with the highest marginal return on invested capital. This second Key benefits arising from a separated FFP typically include: argument is controversial, since it implies that not all decisions are made rationally. There remains, however, the risk that cross • Raising significant funds quickly subsidization can occur between operating units when they are • Driving improved managerial focus jointly managed. The mere potential to obscure underperformance • Creating greater investor transparency in the core airline’s operation could lead skeptical investors to discount a combined entity. The liquidity factor. The ability to raise significant funding is often cited as the primary motive behind loyalty franchise monetization. Early on, these divestitures might have been Ensuring a Successful Separation associated with airlines that were on the verge of insolvency. For airlines, it is important to build a separation architecture that However, recent moves by Qantas and Lufthansa to separate does not cede undue control. Unless clear provisions are made in their FFPs without immediately seeking outside capital suggest advance, dividing the program financially and operationally from the “distressed imperative” is not the only factor. the parent company can affect the airline’s ability to promote repeated high-value behaviors among the customer base. Dedicated management. A carved-out loyalty business (“LoyaltyCo”) can attract and harness the energy of a talented As a first step, the organization must examine its prevailing leadership team (often with a different managerial skill set). This policies around the spread (i.e., gross margin on points), float team is exclusively focused on optimizing LoyaltyCo’s stand-alone (i.e., working capital) and breakage (i.e., expired currency) marketing services, capabilities and value, often freeing the associated with the loyalty program. It is also critical to ensure business to grow with fewer constraints. When autonomously that the internal carrying cost of the currency accurately managed, a loyalty program arguably has more license to represents the slate of future liabilities associated with benefit aggressively pursue inorganic expansion. We observe that fulfillment. Even for publicly traded companies subject to IFRIC separated FFPs are also forced by the market to be increasingly 13, the internal mechanism for valuing the nominal “point” is competitive in areas such as CRM, merchandising and promotion. often inadequate when it comes to a separation. In L.E.K.’s They also tend to be more assertive in enlisting a diverse set of experience, determining and validating this metric is a key initial partners capable of enhancing everyday program relevance. activity in a successful separation. Create greater investor transparency. Another benefit is the Operationally, transitioning from an in-house program to a ability to grant investors greater insight into enterprise financials separated entity must be tightly choreographed to ensure that were not previously shared, understood or appropriately continuity in service delivery. For many organizations the valued. Indeed, the presence of a “conglomerate discount” has question of “who owns the customer relationship” becomes a led various global carriers to divest seemingly symbiotic assets stumbling block when core CRM technology systems are such as technology platforms, maintenance divisions and divided. This conflict can extend to third-party coalition partners regional operations. Observable market multiples for airlines who are integral to the program’s economics (i.e., co-branded versus consumer marketing companies notionally support the credit card providers). The point of delineation is often between assertion that the two distinct business profiles can be worth recognition and accrual/redemption, with the airline owning the more separated than together. The rationale behind this is that former and the loyalty program owning the latter. Regardless of a combined entity, run by traditional airline executives, can bias the ultimate split, it is imperative that a level of real-time data capital decisions to what these executives know best. access (i.e., customer knowledge) and robust communication channels be retained for all parties to the agreement. In other words, “inefficient” economic outcomes can result if cash flows generated by the loyalty program are reinvested to Page 2 L.E.K. Consulting / Executive Insights Volume XVII, Issue 23 INSIGHTS@WORK® LEK.COM EXECUTIVE INSIGHTS Once the financial model has been assessed and the operating Lastly, given the airline’s presence as the anchor tenant to the platform defined, the organization can begin to address a loyalty coalition, the balance of power around accrual and re- broader set of equally important issues to increase the likelihood demption must be thoughtfully designed. This is necessitated by of commercial success post-separation. the imbalance between a proliferation of accrual sources and a relatively fixed supply of “compelling” redemption opportunities. Drawing the Lines for Longevity With redemption demand growing faster than supply, LoyaltyCo might need to pay higher rates in order to maintain the health While the separation of LoyaltyCo from the airline implies of the program. There is also a risk that miles converge to some greater autonomy, the extent of this independence raises a completely transparent standard (say, some factor of a penny number of strategic questions, including: per mile), thereby commoditizing the currency. Preventing this spiral through carefully crafted redemption frameworks is critical • What merger and acquisition alternatives to maintaining the allure, and long-term health, of the program. will be permitted? • What coalition development freedoms Unlocking Liquidity Through Separation will be allowed? • What is the appropriate accrual/redemption Over the past decade, airlines have derived nearly $3 billion framework? in liquidity from partial or full loyalty program separation. The eight transactions that have been completed to date cover a wide The first issue concerns the ability of the separated loyalty entity range of geographies, transaction sizes and airline operating to make acquisitions and divestitures with or without the models (see Figure 2). For the airlines pursuing monetization consent of the airline. For a number of reasons, the possibility in a non-distressed situation, the process generally occurred of capturing value through consolidation will hold some of the over the course of one to two years, with an initial architectural greatest appeal to potential investors. Accordingly, the airline separation forming the base for a subsequent liquidity event. needs to consider how it trades off the potential value of conferring this flexibility with potential conflicts of interest (or For airlines considering partial or full separation of their FFP, conflicts of focus). there are a series of questions that should be addressed to ensure the concept is both financially sound and tactically achievable. The second involves the degrees of freedom that the airline For starters, how much value can be realistically captured from a grants to LoyaltyCo to strike outside partnerships or to pursue separation? While comparable transactions provide a represen- a broader coalition. Clearly,